we revisit the question of why fixed rent contracts are
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Fabella, Raul V.
Working Paper
Why fixed rent contracts are less prevalent: Weakthird party enforcement and endogenous principaltype
UPSE Discussion Paper, No. 2016-06
Provided in Cooperation with:University of the Philippines School of Economics (UPSE)
Suggested Citation: Fabella, Raul V. (2016) : Why fixed rent contracts are less prevalent: Weakthird party enforcement and endogenous principal type, UPSE Discussion Paper, No. 2016-06,University of the Philippines, School of Economics (UPSE), Quezon City
This Version is available at:http://hdl.handle.net/10419/162632
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University of the Philippines School of Economics and
National Academy of Science and Technology
Discussion Paper No. 2016-06 August 2016
Why Fixed Rent Contracts are Less Prevalent: Weak Third Party Enforcement and Endogenous Principal Type
by
Raul V. Fabella
Why Fixed Rent Contracts are Less Prevalent: Weak Third Party Enforcement and Endogenous Principal Type
by
Raul V. Fabella
School of Economics University of the Philippines
Abstract
We revisit the question of why fixed rent contracts are less prevalent than crop share contracts despite Marshallian inefficiency. We consider the case where the type of the principal is endogenous to contract provisions and reneging by the principal may pay due to weak third party enforcement (TPE). We imbed the quality of TPE into the participation constraint of the agent in an effort-in-advance P-A model. The governance regime explicitly involves interplay of three categories of the Northian enforcement, viz., first, second and third party enforcement. Weak and strong TPE are formally defined. We show that the general contract derived nests the usual textbook contract when TPE is strong; weak TPE on the other hand results in a strictly positive induced risk aversion which always exceeds the inherent risk aversion of the agent. This prevents the power of the contract to equal one even when the agent is risk-neutral, thus, rendering a fixed-rent contract sub-optimal. JEL Classification D23, D82, D86 Key words: sharecropping, weak TPE, endogenous type, induced risk aversion Mailing address: Dr. Raul V. Fabella School of Economics University of the Philippines Diliman, Quezon City 1101 Email: [email protected]; [email protected]
Acknowledgments: The author thanks Ma. Cristina Bernido-Fabella for excellent editorial help.
1. Introduction
Why are fixed rent contracts (FRC) less prevalent than mid-range agricultural
contracts, such as share contracts, despite the classical observation (Smith, 1776; Mill,
1848) made salient by Alfred Marshall’s famous footnote (1920) that input use in crop
share land will be lower than in own or leased land (see, e.g., Dubois, 2008)? Empirical
results seem to favor this view: Shaban (1987) empirically demonstrated that input use in
crop share land was significantly lower than input use in owned land and a priori in fixed
rent lands. This is corroborated by Laffont and Matuosi (1995) who show that
sharecroppers exert less effort than fixed renters. Obviously, factors other than efficiency
are at work to make share or mid-range contracting desirable. Braido (2006) however
claims that soil quality must be controlled for as crop share lands are generally of lower
quality. When such controls are employed the difference in effort by contract chosen
appears to diminish.
D. Gale Johnson (1950) argued that repeated contracting could make the
productivity of sharecropped land comparable to that under fixed rent contracts. Cheung
(1969), echoing Johnson, argued absent transactions cost sufficient competition will
mimic a competitive labor market and thus efficient; but with transactions cost such as
effort monitoring share contracts mitigates labor shirking relative to the fixed wage
contract (FWC) and allows risk sharing as against fixed rent contracts under output
volatility. Hoffman (1984) showed for example that distant lands tend to be leased by
fixed rent contracts based on historical data on 83 contracts in 16th century France. Allen
and Lueck (1992) also show a higher tendency for share contracts (SC) with lower crop
division cost. Transaction cost and agency cost was also the motivation of Roumasset and
2
Uy (1987) and Roumasset (1995) for SC desirability where agents provide multiple
inputs making for high monitoring cost. Multi-task models result in moral hazard
associated with substitution of effort across tasks which sharecropping can handle better
(Luporini and Parigi, 1996). For Joseph Stiglitz (1974), SC provided the optimal tradeoff
between risk sharing and incentives for effort. But evidence for the risk sharing motive
itself is empirically mixed (Braido, 2005). Allen and Lueck (1992) using crop variability,
viz., corn and wheat, conclude that risk sharing is not compelling motive. Laffont and
Matuosi (1995) also claim that tenant’s wealth, a proxy for risk aversion, does not figure
as determinant in the power of contracts in Tunisia. By contrast, Ackerberg and Botticini
(2002), by accounting for the endogeneity of contract choice, find a positive correlation
between the tenant’s contract share and the tenants’ wealth in support of the insurance
motive assuming that wealth is a good proxy for risk aversion. Dubois (2002) also show
that measured risk aversion index correlates positively with lower powered contracts after
controlling for the endogeneity of contract choice. Dubois (2002; 2008) following
Johnson (1950) and Adam Smith (1776) shows how non-contractible land quality can
explain sharecropping when this enters separately into the landlord’s utility function.
Dubois shows that a fixed rent contract is not optimal even with risk neutral tenant.
Limited liability, which motivates the tenant’s willingness to take on more risk under a
high powered contract, is a possible motive for SC (Shetty (1988). Ghatak and Pandey
(2000) combines limited liability and a multi-task feature to show that optimal tenancy
contract with joint moral hazard in effort and output risk even without risk neutrality of
tenants.
3
Skill level may be a crucial contract choice factor. Eswaran and Kotwal (1985)
deduced SCs where unobserved skills of the players affect output. Muthoo (1998)
showed that, starting from moral hazard on the tenant’s skill level, no uncertainty and full
risk-neutrality, FRCs are best for tenants with high skill level while those with low skills
work for SC or FWC in the no-renegotiation regime; FRC is only a possibility absent the
no-renegotiation condition. Sen (2011) employed price volatility and imperfect
competition in the rural product markets to show that the unique contract type robust to
the emergence of third agent competing with the landlord is sharecropping.
Imperfect capital market naturally suggests itself as argument in contract choice.
Laffont and Matuosi (1995) showed that the power of the contract in Tunisia is
negatively related to the landlord’s working capital and positively related to the tenant’s
working capital. Exogenous influences such as crop volatility appears to factor in as well.
Pandey (2000) showed that the noisier the output, the lower is the power of the
sharecroppers’ contracts. Canjels (1998) showed that the likelihood of a plot being under
a SC is positively related to the measured risk. But Allen and Lueck (1999) show that
output risk does not have a positive impact on the probability of a crop being leased
under sharecropping.
Property rights have surfaced severally in the empirical and theoretical literature.
For Laffont and Matoussi (1995), crop sharing might constitute a way for the landlord to
extract the tenant’s surplus due to, as Braido (2005) put it, “the lack of enforceable
mechanisms available to the principal to extract the tenant’s surplus.” Thus, the
landlord’s preference for SC hangs on weak enforcement. Security of tenure emerges as
explanation for differential investment by tenants in owned versus leased land. That
4
owned lands are less likely to be subject to expropriation seems to explain more specific
investments in owned lands than in leased lands in Pakistan (Jacoby and Mansuri, 2006);
Bandiera (2003) shows that fruit trees are more likely to be grown by Nicaraguan farmers
in their owned lands than in leased lands for the same reason.
An interesting observation on the literature is that contract choice outcomes tend
to be interpreted from the preference of the landlord or principal. But the tenant or agent
may also reject a take-it-or-leave-it contract offer opting instead for another contract that,
say, improves long-term stability. Banerjee and Ghatak (2004) show that eviction threats
or absence of property rights security can induce long-term investment by tenants where
long-term investments can stay the hand of the potential evictor. The tack we take here
dovetails the Laffont and Mattuosi view of the absence of adequate third party
mechanism to extract tenant’s surplus: in our case, however, it is the tenant’s inability to
compel the landlord to abide by the contract under weak TPE. The tenant may opt for a
contract that shares the bounty of a bumper harvest with the landlord to reduce the
likelihood of hold-up by the landlord.
Third party enforcement or public ordering made salient by the work of Douglass
North (1990) and Oliver Williamson (1985) though most influential in contract theory in
general (see e.g., Glanchant and Brousseau, 2002; Malin and Mortimort, 2002) seems to
have been given little explicit role in the sharecropping puzzle. Strong TPE is a canonical
assumption of orthodox contract theory and TPE weakness is countenanced only when
some contract provision is unenforceable by the TPE. When such is the case, the
incentives compatibility constraint is deployed to render the optimal ex-ante contract
shirking-free ex-post through the granting of informational rent to the agent. But reneging
5
or hold-up can also be perpetrated by the landlords who, being normally wealthier, may
in fact wield more political influence than a tenant in a locality.
The view of North and Williamson that a good deal of economic
underdevelopment in many LDCs can be explained by weak TPE is especially pregnant
in the contract space. As North (1994) put it: “The inability of societies to develop
effective low cost enforcement is the most important source of both historical and
contemporary underdevelopment in the Third World.” Strong TPE allows contracts to
navigate the asynchrony in the quid and the quo of contracts allowing greater contracting
options and deeper markets (Williamson, 1983). Weak TPE severely narrows the mid-
range contracting space to small coherent groups where threat of penalty is effective. As
we will show here, one way it does so is to effectively bar fixed rate contracts.
Weak TPE may be in part due to one of the contractors being himself associated
in the contract enforcement. The state which supplies enforcement services in its
jurisdiction may for example be also either a principal or a partner in many long-term
contracts with the private sector participants. When the state has a weak commitment to
the rule of law, it may be unable to resist the popular clamor for change in rules in times a
private sector partner is showing profits. This surfaced recently in Metro-Manila,
Philippines, where the state regulator of water services, the Metropolitan Water and
Services System (MWSS), decided to deny the tariff adjustment petition of the two
private water service concessionaires, the Manila Water Company and Maynilad Water
Company, on the grounds of a new and different interpretation of the income tax
privilege of concessionaires in the governing concession contract. This, it seems upon
seeing that the concessionaires have begun showing profits since previous dispensations
6
did not raise the issue when the concessionaires were still struggling. The concessionaires
view this as a violation of the concession contract which, had it been known ex-ante,
would have changed their behavior or even deterred them from signing up. The issue is
still under dispute (Wallace, 2015) “This gov’t does not honor contracts” Inquirer
Opinion, ABS-CBN News, Aug 10, 2015; Philippine Center for Investigative Journalism
(PCIJ), July 4, 2013). The behavior of the principal may thus be dependent on the
observed outcomes.
The crucial assumption we make here is that the type of the principal/landlord
may be endogenous to the realized outcome of the contract and hold-up by the landlord
may pay due to weak TPE. This feature of endogenous principal type is in accord with
North’s (1994) concept of “evolving mental models” where the behavioral type of players
may vary to accord with changing perception of circumstances and information. This is
also consistent with new results in cognitive psychology (see e.g., Costa-Gomez and
Weizsacker, 2008; Post et al., 2008). Contract theory already allows for multiple
behavioral types in the population but each agent has one fixed type. This already allows
an average variable, say, quality, to be endogenous which motivates, for example, credit
rationing in the Stiglitz-Weiss credit rationing model (1981) where the high interest rate
induces the flocking of bad borrowers that raises the risk load of loan portfolios.
In this paper, it is the size of the realized wage that may induce the principal to
shift types from abider type to hold-up type. Perhaps closest to this view in incomplete
contract theory is the tradeoff between rigidity and flexibility and the Hart and Moore’s
(2007) idea of “shading” on effort by parties under different contractual regimes.
Sharecropping is flexible as to the returns to the landlord while fixed rent is rigid. In a
7
fixed rent contract there is no adjusting to the state of nature. This may motivate hold-up
by the principal in times of plenty and peasant revolt in times of scarcity (Scott, 1976). In
our case however, the choice of ex-ante contract is precisely to avoid costly hold-up.
The power of the contract defined as the degree of responsiveness of the agent’s
pay to the realized/observed output/revenue is an important concept in contract choice
theory. In a pure risk-sharing environment (i.e., with observable effort and random
output), the power of the contract is determined solely by the risk attitudes of the
principal P and the agent A. When w’(x) = 1, we say that FRC solves the optimal contract
problem. Thus, under a strong TPE, the contract choice is determined solely by the
inherent risk attitudes of players. Under weak TPE, this may no longer be the case.
When TPE is weak and the contract is effort-in-advance, the principal may
withhold the future payment. The principal, who delivers his contract obligation last,
enjoys what Hume (1769) called the “possession of advantage.” This asymmetric
empowerment alters the power of the contract.
In this paper, we explicitly imbed the TPE feature in the design of an effort-in-
advance adverse selection contracting model general enough to apply to both strong and
weak TPE environments. In the latter case, P may benefit by refusing to fully honor the
contracted wage, especially in instances when the contracted wage is especially high.
Thus, the type of the principal is endogenous to the quality of TPE and the realized
outcome. To focus analysis on the adverse selection and the governance angles, we
eschew moral hazard.
We show how contracts tend to combine weak TPE with second party provision;
in this case, the choice of contract to keep the contract within what Klein (1996) calls
8
“the self-enforcing range of the contract.” In Section 2, we present as benchmark the
familiar P-A model where the type of the principal is fixed and known up to a fixed
probability distribution and the implicit underlying TPE is strong. In Section 3, we
explicitly imbed a TPE regime in the participation constraint defining along the way
weak and strong TPE. To relate the type of the principal with the wage rate, the
probability q that the principal abides by the contract is first derived as a positive function
of the TPE regime, a negative function of the contracted wage. In Section 4, we first
show that the derived general contract nests the familiar textbook optimal contract when
TPE is strong. We make a distinction between the inherent risk aversion and the induced
risk aversion of the agent and show that the latter exceeds the former only under weak
TPE. Thus, the power of the contract is always lower under weak―than under
strong―TPE. We then show that a fixed rent contract is never optimal under weak TPE
even when the agent is inherently risk-neutral and principal is risk-averse, conditions
which normally suffice for a fixed rent contract under strong TPE. The reason is that the
agent’s induced risk aversion in weak TPE regimes exceeds zero even as the inherent risk
aversion is zero. We summarize in Section 5.
2. The Benchmark Model
In this section, we present the textbook model of optimal contract which will
serve as benchmark for our result in the next section. Consider the case of a principal P
producing revenue x using the services e of one agent A. Revenue x is a random variable
with density function f(x, e), x ∈ X, e is effort and f ′ = (∂f/∂e) > 0. Revenue x is costlessly
observable ex-post. P’s utility is B(π), π = x – w, where π is profit, w is the wage of A and
9
w, e
B′ > 0, B′′ < 0. A’s utility is U(w(x), e) = u(w(x)) – v(e) where u′(w) > 0, u′′(w) < 0 and
v′(e) > 0, v′′(e) > 0. A’s reservation utility is U0. To isolate the problem of governance, we
let e be costlessly observable. The optimal contract C(w, e) solves the problem P.1 as
follows:
max ∫ B(x – w)f(x, e)dx (1)
s.t. ∫ [u(w(x)) – v(e)] f(x, e)dx > U0.
The first order conditions for an interior maximum are:
(i) -B′(x – w) + λu′(w) = 0
(2) (ii) B(x – w) + λ[(u(w) – v′(e))] = 0.
(2)(i) implies that λ > 0 and the participation constraint (PC) in (1) holds as equality.
Combining (2.i) and (2.ii) eliminates λ and generates the efficiency condition which,
together with the PC, forms two equations in two unknowns w and e. Solving for w and e
gives the optimal risk sharing contract C(w0, e0). The cost of the contract to the principal
is w0.
Differentiating (2.i) with respect to x, substituting for λ and solving for w′(x)
gives the standard power of the contract, w′(x)0:
w′(x)0 = RP(RP + RA)-1, (3)
10
where RP = (B′′/B′) and RA = -(u′′/u′) are Arrow-Pratt measures of absolute risk aversion
for P and A, respectively. We will call RA the inherent absolute risk-aversion of A since
it is based on A’s utility function alone. w′(x)0 measures the responsiveness of w to
actually observed x and 0 < w′(x)0 < 1. If RP = 0, (B′′ = 0), and A is risk-averse, then w′
(x)0 = 0, so the contract is a fixed wage contract where P bears all and A bears no risk. If
RP > 0 and RA = 0, w′(x)0 = 1 and the contract is a franchise or a pure rent contract and A
bears all the risk while P bears no risk by receiving a fixed rent.
If w′(x)0 > 0, then part or even the entire wage is necessarily paid after realized x
is observed at the end of the cycle. This comes as a share of the surplus or output. As
long as part of the payment is delayed till the end of the cycle, it is vulnerable to ex-post
opportunism since effort e0 once expended cannot be redeployed and thus has the
property of asset specificity.
Suppose the reneging principal pays A not the contracted w* but something less,
w0. For example, in a linear effort-in-advance contract, w = a + bx, P may withhold bx
and A receives only w0 = a. P’s ex-post profit will be higher by bx. The textbook
contracting literature says that P will not renege because there is an outside third party
that will mete out a penalty L > bx on P with probability one. Thus, effort-in-advance
contracts become insulated from ex-post opportunism in a strong TPE environment.
Another way of stating this is that strong TPE dissolves the distinction between spot and
forward contracts. Unfortunately and especially in developing economies, the
enforcement environment is not so reliable as was shown in our example on water
concession contracts in Metro-Manila.
11
3. The TPE Environment
A. Principal Type
Suppose that P has only two options, either to pay the contracted wage w or to
pay a fixed w0 < w. The issue is the likelihood that P will renege, i.e., pay only w0 in a
particular TPE environment. If TPE is strong, P will never renege since the subsequent
punishment is certain and by definition in excess of opportunism gain. If TPE is weak, P
may be tempted to renege if the gain attached to the opportunism is substantial and
exceeds the expected penalty. In this case, P’s type is endogenous.
Suppose there are N potential principals producing x using the same technology.
Let g be the probability of being punished and L > 0 be the statutory penalty attached to
P’s reneging on the contract of this type. The typical (see, e.g., Cooter, 1996) expected
benefit, Eri, i = 1, 2,…, n, from reneging is thus:
Eri = (w – w0) – gL – Ai, i = 1, 2,…, N (4)
where Ai > 0 is Pi’s personal conscience cost of reneging by i, (w – w0) is the gain from
paying w0 instead of the full w. Suppose Ai is uniformly distributed in the interval [0, A0]
where A0 is the highest possible conscience cost. Note that Pi abides by the contract if Eri
< 0 or Ai > (w – w0) – gL. The probability that any randomly drawn Pi is an abider (i.e.,
pays the contracted wage w) is, in view of the uniform distribution, (1 – Ai/A0) = q, or
q = [A0 + gL – (w – w0)]/A0. (5)
Agent A knows A0, g, L and w0 which are public knowledge ex-ante. The interesting
aspect is that the likelihood, q, that the principal is an abider depends not only on the TPE
12
quality, gL, and the inherent rectitude A0 of the principal but also on contract provision w.
It is linear and negative in w. A0, the conscience cost of reneging, stands for North’s first
party enforcement while gL is proxy for North’s TPE. The contract structure which is
endogenous to TPE is proxy for North’s second party enforcement (SPE). The present
model thus exhibits interplay between the three Northian enforcement categories in
optimal contracts. Note that as A0 becomes very large, q approaches 1 or the principal is
an abider. This may be the case within small coherent groups where hardwired abidance
is the norm. The same happens if gL becomes very large. But where these two factors are
weak, a rising w can reduce the likelihood of compliance by P.
B. A’s Expected Utility
When q < 1, the PC of A is
∫ [qu(w) + (1 – q)u(w0) – v(e)] f(x, e)dx > U0. (6)
The analysis assumes a strictly positive expected marginal utility of w, i.e.,
∫ [qu′(w) + q′(u(w) – u(w0))] f(x, e)dx > 0 (7)
which, however, is lower than when q is exogenous since q′ < 0. A’s benefit from
increased w is tempered by the higher likelihood that P will cross over to being a
renegade. Of course, if q = 1 and q’ = 0, (7) reduces to ∫u′(w)f(.)dx, the familiar textbook
expected marginal utility of w to A.
C. Taxonomy of TPE
13
Definition 1: (i) The TPE environment is strong if gL ≥ (w – w0), that is, if q ≥ 1
(truncated as q = 1) and q’ = 0; (ii) It is weak if gL < (w – w0) that is, if q <
1 and q’ < 0.
Remark: (1.i) says that the penalty meted by the TPE for opportunism by P
exceeds the gain (w – w0) from the same act. If TPE is absent (gL = 0), q
< 1 and q’ < 0.
D. Contract Structure
P now solves the programming problem P.2, which maximizes the same objective
function as in (1) subject to the new PC given by (6). The first order necessary condition
for an interior maximum are:
(i) -B′ + λ[qu′(w) + q′(u(w) – u(w0))] = 0
(8) (ii) B(x – w) + λ(qu(w) + (1 – q)u(w0) – v′) = 0.
Since the expected marginal utility to A of w is always positive by (7), λ > 0 from
(8.i) and the PC binds as equality. Combining (8.i) and (8.ii) gives the efficiency
condition which together with the PC can be solved for the generalized optimal contract
C(w**, e**). If we let q = 1 and q’ = 0, (8) exactly reduces to (2) above and the resulting
contracts are identical. Therefore, the contract in (2), C(w*, e*), is nested in (8) as a
special case when TPE is strong. Likewise, C(w**, e**) approaches C(w*, e*) in the
limit as A0 approaches infinity, that is, if the conscience cost A0 of reneging, is infinite.
The foregoing shows that the familiar textbook contract is a special case of the contract
derived here. We formally state this:
14
Proposition 1: (i) (w**, e**) = (w*, e*) if TPE is strong. (ii) (w**, e**) → (w*,
e*) as A0 → ∞.
A multiplicity of types of contract is possible depending on the strength of the TPE. We
now explore the implication of weak TPE on the power of the contract. It is easy to show
that for a given effort level, the optimal wage w is higher under weak TPE, thus making
the contract cheaper for the principal.
4. POWER of the CONTRACT
In this section, we derive the power of the contract under weak TPE as described
above. Differentiating (8.i) with respect to x and solving for w′(x) gives
w′(x) = RP[RP + RA
0]-1 (9)
which differs from (3) only with the replacement of RA by RA
0. Now
RA
0 = -(H′′ + h′)(H′ + h)-1
where
H′′ = qu′′(w) < 0
since
H′ = qu′(w) > 0,
and
h′ = 2q′u′(w) < 0,
since
h = q′[u(w) – u(w0)] < 0
15
and q′ < 0. Thus, RA
0 can be viewed as the induced measure of absolute risk aversion of
the agent. Note that by (7), [H’ + h] > 0. Note also that if q` = 0 (q = 1), RA0 reduces to
RA in (2). We have the following:
Lemma 1: The Induced Index of Absolute Risk Aversion RA
0 has the following
properties: (i) RA0 > RA, that is, the induced index of absolute risk aversion
of A is higher than the inherent index of absolute risk aversion of A under
weak TPE. (ii) RA0 = RA under strong TPE; (iii) RA
0 > 0 under weak TPE
even when the agent is inherently risk-neutral (RA = 0).
Proof: (i) The induce absolute risk aversion of A under weak TPE is RA
0 = -(H′′
+ h′)(H′ + h)-1. The same under strong TPE is [-(H′′)(H′)-1] = [-(u′′ (w)/u′
(w))] = RA. But h′ < 0 under weak TPE and when added to H′′ < 0 only
raises the numerator, while h < 0 under weak TPE added to H′ > 0 reduces
the denominator which however remains positive by (7). Thus, RA0 > RA.
(ii) Under strong TPE both h, h′ = 0 since q′ = 0. Thus, RA0 = RA. (iii)
Suppose A is risk neutral, u′′(w) = 0, then RA0 = -(h′)(H′ + h)-1 > 0. In
contrast to RA = 0 when u′′(w) = 0. Thus, RA0 > RA when A is risk-neutral.
QED
Proposition 2: (i) w′(x) = w′(x)0, when TPE is strong. (ii) w′(x) < w′(x)0 when
TPE is weak.
16
Proof: (i) If TPE is strong, RA0 = RA from the Lemma 1 and w’(x) = w’(x)0; (ii) If
TPE is weak, RA0 > RA, so w′(x) < w′(x)0 by Lemma 1. Q.E.D.
Thus, the power of the contract under strong TPE is nested in the power of the contract
under the more general model. When A knows that a very generous offer by P (high w)
has no effect on the likelihood of contract abidance by P, the power of the contract is
unaffected. Otherwise, the power of the contract will respond. Why this happens is of
interest. The advantage of a high powered contract is that A shares in high realizations of
x. But it is also in those times when the gain from reneging (w(x) – wo) is higher and the
temptation for P to renege is stronger under weak TPE. An instance of induced risk
aversion sometimes occurs in the financial sector: when a bank starts to offer abnormally
high interest on savings deposits, alert depositors become more vigilant because a default
may be in the offing. In effect, A is induced towards more risk aversion. A corollary of
(2.ii) is that the combination of inherent risk neutrality in A and strict risk aversion in P
under weak TPE do not suffice to make a franchise/fixed rent contract optimal as they do
under strong TPE.
Proposition 3: (Sub-optimality of Fixed Rent Contracts Under Weak TPE):
Suppose A is inherently risk-neutral (u′′ = 0) and P is strictly risk-averse
(B′′ < 0). If TPE is weak, w’(x) < 1, the fixed wage contract is never
optimal.
Proof: A fixed rent contract under a weak TPE requires w’(x) = 1. But by Lemma
(1.iii), RA0 > 0 under risk neutrality in A. Thus, w′(x) < 1 or a fixed rent
contract is never optimal under weak TPE. QED
17
The more power a contract has, the greater the likelihood of a hold-up by P under
weak TPE when the x is large. The temptation to renege is especially great in the fixed
rent farm contracts when the harvest is bumper as all the incremental benefits accrues to
A and nothing to P. In this case, the tenant or agent insists that the contract gives landlord
or principal property rights over a part of the best possible outcome; agent A prefers a
contract that divides ex-post rents, as it were, more equitably (Masten, 1988). Similarly
this preference for sharecropping keeps the relationship within the self-enforcing range of
the contract (Klein, 1996). This also instances what Williamson called hazard
equilibration (see, e.g., Masten and Saussier, 2000). This helps explain the more
widespread adoption of share tenancy not only in the past but also still in the present.
This also calls to mind the trade-off between contract flexibility and rigidity
introduced by Hart and Moore (2007) in incomplete contracting. In incomplete
contracting, contracts are left purposely incomplete until the required information
becomes available in the future. There follows a renegotiation to divide the fruits of non-
contractible investments. But due to the sharing ex-post, parties may “shade” on their
effort. A SC is flexible, that is, adjusts returns to parties according to the state of nature
but the tenant may shade on effort; the fixed rent contract elicits full effort but cannot
adjust to the state of nature. In these circumstances, the tenant will either shade on effort
under a fixed rent contract to manage a likelihood of hold-up and recontracting or ex ante
choose the SC to attain the same thing―keep the contract within the self-enforcing range.
This strategy prevents costly hold-up and recontracting.
The application of the view herein proposed naturally goes beyond agriculture.
This may also explain the dominance of large politically connected enterprises (The
18
Economist, 2001, “In Praise of Rules,” Survey of Asian Business). Weak TPE or
alternatively weak rule of law means a constant threat of adverse changes in rules by the
state when business is booming. Connected dealings, like a SC, makes the political
establishment a party to the bounty and thus eases the threat. The phenomenon of large
businesses in many LDCs having either direct or indirect―and many times, elicit
connected dealings with the political establishment―may be viewed from this lens as a
form of an implicit SC where the political establishment, in exchange for the connected
flows, protects the firm from outright expropriation by the state when profit is high. Truly
unconnected and rules-based large private businesses―especially those involved with
basic services such as water and power―run the constant risk of expropriation by rules
change. Only when states have demonstrated credible commitment to the rule of law do
truly unconnected firms become viable. The parliamentary control of government
finances in England (North and Weingast, 1989) was an example of such credible
commitment. This rendered market players comfortable enough not only to extend long
term loans to the sovereign but also to increasingly own and run unconnected large
independent enterprises.
5. Conclusion
Why are FRCs less prevalent than SCs despite the superior efficiency attached to
the former? One reason among others is that under weak TPE, the agent or tenant tries to
reduce the risk of contract reneging by the principal/landlord in times of bumper harvest
to which the landlord has no claim under FRC. A SC does this. We show this by
considering an adverse selection effort-in-advance principal-agent contract where the
19
type of the principal is endogenous to contract terms and the quality of TPE. The
probability that the principal will renege rises with gain from reneging which rises with
the bumper harvest. We formally characterize strong TPE as one that eliminates the
possibility of ex-post opportunism through the certainty of penalty in excess of the gains
from reneging. Weak TPE in contrast leaves room for profitable reneging. When TPE is
strong, the optimal contract in this model is identical to the familiar textbook principal-
agent contract. Thus, the textbook optimal contract model is nested in the more general
model presented here. They differ markedly when TPE is weak. One difference is in the
power of the contract.
The paper first deduces the likelihood that the principal will cross over from
abider to renegade. This likelihood displays an interesting interplay between the three
Northian enforcement categories in the contracting space: first party, second party and
third party enforcement. This likelihood rises with the gain from reneging which rises
with the contracted wage rate. This in turn induces a risk aversion in the agent in excess
of his inherent risk aversion. This impacts the power of the contract. A contract has more
incentive power when A’s pay is more closely tied to the outcome x. But if high w due to
high x also raises the risk of reneging by P, it is less desirable even to a risk neutral A. We
show that the power of the contract under weak TPE is always less than the power of the
same contract under strong TPE. In particular, a fixed rent contract is never optimal even
when the principal is risk-averse and the agent inherently risk neutral. When the harvest
is bumper, the income of the agent from the output under a fixed rent contract spikes and
to which P has no claim. The high return to reneging will tempt the principal to break the
contract and appropriate part of the bumper harvest for himself. Where third party
20
enforcement is weak (the principal may sometimes himself be the contract enforcer, as in
a feudal regime), this contract type will be avoided.
Weak TPE has been implicated as culprit in the poor performance of economies.
Here, we suggest two pathways by which market is fettered and poor performance is
induced by weak TPE. First of all, certain contracts (e.g., the fixed rent contracts) become
barred even when efficient for risk sharing under strong TPE. Thus, weak TPE induces a
shallow market among large heterogeneous populations. Second, the cost of contracts for
upright principals (those with very high A0 and have no intention to renege) rises. In
markets where abiders and renegers compete, the abiders will be selected for extinction.
Thus, the weak TPE also acts as a selection mechanism for poor quality principals and
poor outcomes.
21
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